When Is (Performance-Sensitive) Debt Optimal?

42 Pages Posted: 18 Aug 2021 Last revised: 7 Jul 2022

See all articles by Pierre Chaigneau

Pierre Chaigneau

Queen's University; affiliation not provided to SSRN

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Daniel Gottlieb

London School of Economics

Date Written: June 1, 2022

Abstract

Existing theories of debt consider a single contractible performance measure ("output"). In reality, many other performance signals are also available. It may seem that debt is no longer optimal; for example, if the signals are sufficiently positive, the agent should receive a payment even if output is low. This paper shows that debt remains the optimal contract under additional signals -- they only affect the contractual debt repayment, but not the form of the contract. However, even if a signal is informative in the sense of Holmstrom (1979), it might optimally not be used in the debt contract. We show how the contractual debt repayment should depend on valuable signals, providing a theory of performance-sensitive debt.

Keywords: informativeness principle, limited liability, performance-sensitive debt

JEL Classification: D86, G32, G34, J33

Suggested Citation

Chaigneau, Pierre and Edmans, Alex and Gottlieb, Daniel, When Is (Performance-Sensitive) Debt Optimal? (June 1, 2022). European Corporate Governance Institute – Finance Working Paper 780/2021, Available at SSRN: https://ssrn.com/abstract=3895702 or http://dx.doi.org/10.2139/ssrn.3895702

Pierre Chaigneau (Contact Author)

Queen's University ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

affiliation not provided to SSRN

Alex Edmans

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Daniel Gottlieb

London School of Economics ( email )

New Academic Building 5.30
Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://https://personal.lse.ac.uk/gottlied/

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